But investors should focus on Kindred's strengths, rather than the reimbursement threat. In the past, Medicare's final-rate rules have generally been much less severe than the initial proposals. In fact, a second proposal from the Medicare Administration could result in rates rising 1.5% in the next fiscal year.

In any case, Kindred's pending $1.3 billion acquisition of rival
RehabCare Group,
which has won antitrust clearance and is expected to close in June, will create a powerhouse in acute-care and rehabilitation services. And demand for both will climb as the nation's population ages.

Says CEO Diaz: "It's always been our goal to be the premiere rehab and post-acute care provider in the U.S., and this deal will do that."
Jonathan Robert Willis

Kindred, already the nation's largest provider of long-term acute-care hospital services, will pay RehabCare shareholders $26 in cash and 0.471 of a share of Kindred stock (ticker: KND) for each RehabCare share (RHB). Kindred is also assuming about $400 million of RehabCare's debt. The deal will be aided by $1.6 billion in borrowings, some of which will retire about $766 million of the two companies' debt.

Despite the nearly 40% premium being offered for RehabCare's common, compared with the price on the day before Kindred made its bid on Feb. 8, investors have signalled that they favor the deal. For one thing, it should be highly—and quickly—accretive to Kindred's earnings. For another, it will broaden the company's already diverse array of services. At Friday's close of 25.22, Kindred's stock is up 30%, since the acquisition was announced, while RehabCare's common has soared 48%, to 37.57.

"IT'S UNUSUAL THAT THE SHARES of both companies, especially the acquirer, have appreciated so much before the close," says portfolio manager Bill Hench at Royce & Associates, a New York investment-advisory firm whose $2.4 billion Royce Opportunity Fund has held Kindred off and on over the past five years. "It shows investors have a lot of faith in management." Of the Medicare-reimbursement issue, he counsels: "There's no need to panic. It happens all the time. It's why you can get [nursing-facility and rehab-care stocks] at the price you do. And in this case, it has created a very attractive entry point for people who aren't in the stock."

Kindred, which is based in Louisville, operates in 706 locations in 40 states, including 89 long-term acute-care hospitals and 224 nursing and rehabilitation centers. St. Louis-based RehabCare has 35 long-term acute-care and rehabilitation hospitals, and manages rehab services on a contract basis at about 1,250 hospitals and skilled nursing facilities in 42 states and Puerto Rico.

Kindred Healthcare CEO Paul Diaz tells Barron's in an interview at his corporate headquarters: "Health-care reform is a catalyst for marketplace change. Size, diversity and the capability to provide integrated services at a local level are important. It's always been our goal to be the premiere rehab and post-acute-care provider in the U.S., and this deal will do that."

The 49-year-old executive predicts the combined company will achieve operating cost synergies of approximately $40 million within two years after the transaction closes, with $25 million coming in the first year. "The transaction creates the largest post-acute-care hospital company in the U.S., with more than $6 billion in revenue and operations in 46 states and Puerto Rico," he adds. "It's a win-win for both companies and their shareholders."

Frank Morgan, an RBC Capital Markets analyst, sees the acquisition as "very attractive strategically for Kindred, which stands to gain a significant contract rehab platform." He says it could add 16 cents to Kindred's expected $1.94 a share in earnings this year and 29 cents to 2012's expected $2.11. The company earned $1.42 in 2010.

Not that Kindred is doing badly on its own. In the first quarter, it earned $22.1 million, or 55 cents a share, compared with $14.9 million, or 38 cents, a year earlier. Analysts had expected 48 cents a share. Sales came in at $1.19 billion, up from $1.09 billion.

JPMorgan analyst Scott Hansen, who rates Kindred Overweight, has upped his year-end price target by 50%, to $30. Some other bulls think the stock could move into the mid-30s within a year.

KINDRED IS THE SUCCESSOR TO Vencor, a long-term, acute-care hospital and nursing-home company that went bankrupt in September 1999 after its business was hurt by drastic cuts in Medicare reimbursements.

In April 2001, it emerged from Chapter 11 under the name Kindred. The following January, Diaz, a Cuban-American lawyer and accountant, became president. He immediately began revitalizing the company's image, business and finances through acquisitions and by building new facilities and striking deals with other hospital groups to provide services for their skilled-nursing facilities, hospitals and pharmacies. For example, he signed contracts to operate pulmonary-care units at other hospitals.

The Bottom Line

Kindred Healthcare has risen to around 25 on news of the coming purchase of RehabCare, which is likely to quickly aid its profits. Some bulls see Kindred in the mid-30s in a year.

Amid the continuing debate over Obamacare and alternative proposals (see related article), one idea being considered is "bundled pricing." Under this, insurers would pay a flat fee to cover a patient's care, from the hospital to the rehab facility to the home, says Dan Mendelson, CEO of Avalere Health, a Washington consulting group. "There's been an explosion in the number of patient cases in recent years needing multiple sites of service because these patients have multiple and complex conditions—diabetes, heart disease, hypertension and other ailments," Mendelson notes. "Currently a quarter of Medicare spending is being consumed by 15% of patients because they have five or more chronic conditions."

DIAZ SAYS "THIS IS THE sweet spot for us. "And our combined companies will significantly enhance our ability to service that market segment." With reimbursement rates falling and the full impact—and final shape—of health-care reform unclear, creating scale through consolidation is apt to be a winning concept. "That's why this deal makes senses for Kindred," says analyst A.J. Rice of Susquehanna Financial in New York. He notes that "Kindred has both nursing homes and long-term acute-care hospitals. This deal will boost their long-term acute care and strengthen their position in the rehab-hospital business, which we think is a positive. And RehabCare has less exposure to state Medicaid reimbursements [than Kindred has], so that's a good thing, too."

RehabCare is No. 1 in providing contract rehab services to nursing homes, while Kindred is No. 3, and the combined company will be the leading player in nursing-home services—a growth area, Rice adds. And the new company will be better able to provide a continuum of care, managing patients' conditions over an extended period and improving coordination and delivery of services. After leaving a Kindred acute-care hospital, patients might go through rehab at a RehabCare facility. And their treatment would be coordinated by Kindred doctors in consultation with the patient's own physician.

That ultimately will lead to more money flowing to the bottom line. And that should be healthy for Kindred's stock.

Bigger Will Be Better

The RehabCare deal will give Kindred Healthcare 25% of the market for contract rehabilitation services.